The road ahead

SECTOR SCAN

Both commercial and passenger vehicles should see good volume growth in the next couple of years, though margins might get dented.

With fifty new car models expected to be launched in 2007, Indians are going to be spoilt for choice. And it's not just cars that are in demand. Between January and November this year, more than 10 million automobiles rolled off the assembly lines.

According to the Society of Indian Automobile Manufacturers, that's nearly 17 per cent more than the number of vehicles that auto makers turned out in 2005.

On the bourses though, the performance of auto scrips hasn't been as exciting. In the past year, while the BSE Auto index rose just 25 per cent, the Sensex returned over 53 per cent.

While Tata Motors and Maruti Udyog have outperformed the composite auto index, both having returned 37-38 per cent, Mahindra & Mahindra has surged a whopping 57 per cent.

The Street is pretty sure that the momentum in the top line should sustain, but it's a little anxious about operating margins that are already under pressure.

A smooth ride so far....
The commercial vehicles (CV) segment, comprising nearly 25 per cent of the nearly 15 lakh strong four-wheeler (commercial and passenger vehicles) market has been the star performer this year.

Between April and November this year, while domestic CV sales grew by a robust 36 per cent to 3.25 lakh units, exports rose by over 28 per cent as compared to the same period last year.

The growth in the segment far outstripped the 21 per cent growth in the passenger vehicle segment. That's not surprising. With the economy growing at a fast clip and the road network growing thanks to programmes such as the Golden Quadrilateral and the North -South-East-West corridor, demand for commercial vehicles has been on the rise.

...but there are speed breakers ahead
Manufacturers have, however, faced cost pressures which have dented operating profit margins. With prices of several raw materials such as aluminium, copper, chromium and rubber having increased, margins have been affected.

The average price of natural rubber increased 48 per cent between April and November, which resulted in tyre prices rising 20 per cent. Since CVs require a large number of tyres, this has severely affected CV makers.

Industry experts believe that the present growth levels appear unsustainable.

Says Huzaifa Suratwala, research analyst, Emkay Shares and Stock Brokers, "We could see 2006-07 end with an estimated 30 per cent growth. But things could moderate in FY08 to 16-17 per cent."

This seems especially true for the truck segment which has witnessed a whopping 44 per cent increase in domestic sales over April to November 2006. Some part of the increased demand was the result of the Supreme Court ban on overloading trucks in November 2005. This ban has proved to be a blessing for truck manufacturers.

However, the demand which was created because of the ban on overloading should taper off by 2008. Operating margins could be under pressure. Estimates suggest that Tata Motors' operating profit margins could decline marginally from 12.9 per cent in FY06 to 12.1 per cent for FY07 and around 11.9 per cent in 2008.

However, the economy's galloping along""industrial production recorded a robust 10.3 per cent in April to October 2006 and the lower growth in October could well turn out to be a blip. And with that most segments of CVs are expected to benefit.

"With the industry adopting the hub and spoke model, demand for high as well as low tonnage trucks should drive sales at the expense of the medium category," explains Emkay's Suratwala.

According to estimates, vehicles with a gross tonnage of between 7.5 to 16 tonne could see a dip in share of domestic demand from 53 per cent in FY06 to 39 per cent in FY07. Lower fuel cost per tonne and better infrastructure also appear to favour multi-axle, haulage and other similar trucks of over 16 tonne gross weight.

The launch of Tata Ace in May 2005 has opened up a new lucrative market in the sub-one tonne arena and several other companies want to jump into the fray.

With almost all CV majors including Force Motors, Ashok Leyland and even car maker Hyundai Motors eyeing the one-tonne segment, increasing competition could put pressure on prices. 
 

ASSEMBLY LINES BUZZING
Domestic sales (nos)	2003-04	2004-05	2005-06
Medium & heavy commercial vehicles	161395	198506	207446
LCV's	98719	119924	143237
CV's total	260114	318430	350683
Passenger cars	696153	820179	882094
Utility vehicles	146388	176360	194577
MPV's	59555	65033	66366
Passenger vehicles (total)	902096	1061572	1143037
Source: SIAM

The road-rail contest
The CV industry will have to contend with the increasing efficiency of the Railways. The simplified fare structure, regularisation of additional load and procurement of more wagons have seen a more than expected increase in freight at nearly 11 per cent in FY06 compared to FY05.

In fact, between June- August 2006, revenues are already up 16 per cent. Double stack containers have been introduced on select routes and plans are afoot to bring in multi-stacks. Moreover, with private players entering the freight container space, the railways will be better placed to compete with roads in non-bulk commodities.

However, the rail threat will impact the fortunes of CVs makers only in the long term. "The Rs 66-billion dedicated freight corridor is only at the drawing board stage but could be a threat for CVs in the long run," explains Ashutosh Goel, auto analyst, Edelweiss Securities.

"We do not expect any significant threat to the roads sector in the short to medium term," he adds.

The passenger car story
Car production crossed the one-million mark between January-November 2006, driven by the nearly 19 per cent growth y-o-y in the mini and compact segment, constituting nearly 70 per cent of current car domestic sales.

Maruti's net sales grew 15.6 per cent and profit after tax by a whopping 51 per cent in the first half FY07. Though raw materials have not yet impacted Maruti's cost structure, there is a chance that high aluminium prices (up 44 per cent between July 2005 and October this year), may start denting profitability. The rise in steel prices by 15 to 20 per cent since October 2006 may also impact margins in the second half of FY07.

Ad rates too have risen"" the cost for a 10-second spot has risen 15-20 per cent more since March. The competition has been severe in the compact segment which comprises 69 per cent of the market and includes the likes of Maruti Alto, Tata Indica Xeta and Hyundai Santro.

The Zen Estilo from the Maruti stable is the latest to be launched and with four major players, pricing is competitive. Another round of discounts could make the price cost equation go completely awry.

Concerns include rising interest rates""nearly 75 to 80 per cent of car purchases are made through bank loans. However car makers can breathe easy.

"With strong growth in disposable incomes and only a marginal change in EMIs, we do not expect interest rate hikes to have a major impact on demand," says Edelweiss' Goel. The element of fuel costs also continues to remain a worry with both passenger car and CV makers. 
 

VALUATIONS
	Current price (Rs)	EPS FY200 7E	FY200 8E	P/E FY200 7E	FY200 8E
Tata motors	853.00	54.50	59.00	15.60	14.40
M&M	787.00	64.00	73.00	12.20	10.70
Maruti udyog	903.00	51.50	61.50	17.50	14.70
Ashok Leyland	42.00	3.30	3.10	12.70	13.50
Source: Analysts

Global handshake
With domestic firms tying up with international majors, competition can only increase. While the Renault-Mahindra combine looks set to roll out the Logan sedan next year, the Fiat-Tata alliance may take some time.

"International tie-ups are a win-win situation", explains Goel, "Global players get local market access while local players get access to technology as also to new markets."

The last year has also witnessed a surge in foreign direct investment in the segment""the Rs 2500-crore investment by Volkswagen in Chakan, Maharashtra is a case in point. Domestic majors are also stepping up capacity to avail of fiscal sops in states like Uttaranchal.

Export thrust
Exports have emerged as an option for auto makers""in the last three years, they have recorded a compound annualised growth rate of nearly 38 per cent, albeit on a low base. There has been a rise in the contribution of exports to total sales from 4.9 per cent three years ago to over 8 per cent at present.

According to a recent KPMG-CII study, Indian automobile players plan to double the share of their exports in the next five years. However, export margins for four wheelers are less than or equal to domestic margins.

"Greater export orientation could be seen as a de-risking strategy from domestic market uncertainties", explains Suratwala. Besides, global auto majors are increasingly looking to capitalise on the low manufacturing costs. In fact multinational corporations contribute 77 per cent of small car and 88 per cent of all mid-sized car exports.

Tata Motors
Between January and September this year, Tata Motors has consistently outperformed the Sensex. This was because of a strong performance in HI FY07 with reported profit after tax increasing 35 per cent and net sales rising by a whopping 42 per cent. However, since October, the stock has underperformed the Sensex.

Also, analysts do not expect the company to maintain its FY06 operating profit margin of 12.9 per cent, which could fall as low as 12 per cent this year. Increasing competition in the LCV segment could put pressure on the prices of its vehicles in the near term and hence margins.

"It appears that the increased rate of product launch as also depreciation costs along with input costs could affect earnings," comments an analyst at a domestic brokerage firm. However, overall Suratwala would recommend a "buy".

He says, "Tata Motors will be the biggest beneficiary of the automobile boom due to its wide product range," adding, "valuations are also attractive at 12 times estimated consolidated FY08 earnings."

Maruti
Maruti has enjoyed strong operating margins of around 14 per cent for four quarters till September quarter 2006. The A2 or compact segment remains the chief growth driver with Alto clocking record sales of 22,000 in October.

Industry watchers are keenly awaiting the forthcoming launch of the diesel version of Swift, which is expected to give Maruti a leg-up. The A1 or entry level segment continues to have weak prospects""between April and November, domestic sales of Maruti 800 declined by 6.8 per cent.

All indications point to further pressure on margins. "Valuations are stretched, yet its prospects remain good," concludes Goel, "We are recommending an "accumulate" or "buy on decline" on the stock"

Mahindra & Mahindra
M&M has bucked the general trend and has consistently performed better than the Sensex since December last year. In fact, the stock has surged by 57 per cent in contrast to the Sensex rising 53 per cent.

Over the last three months, it has also outperformed other industry majors. The utility vehicle segment has been the underdog of passenger vehicles (comprising cars, utility vehicles and multi-purpose vehicles) category, growing by a rate of 10 per cent compared to the overall passenger vehicle growth rate of 17.5 per cent. But the company has aggressive diversification plans.

The joint venture with Renault in the passenger vehicle as also the tie-up with US-based ITEC (International Truck and Engine Corporation) in the commercial vehicle segment appears to be indicative of this. The diverse portfolio including the automotive components division also remains an asset.

"With the restructuring of the LCV business and the benefits of operating in tax-free zones, M&M appears all set to sustain margins better than other players," says Piyush Parag, auto analyst, Brics Securities.

Ashok Leyland
Ashok Leyland's dependence on the truck segment remains both a strength as well as a weakness for the company. While it could benefit from the sectoral move towards heavy tonnage trucks, it also remains far more vulnerable than Tata Motors to the prospect of new entrants.

The company has shown a degree of diversifying its basket by entering the defence sector. It continues to maintain a strong presence in the bus segment, though these form about a small proportion of its total vehicle sales. Yet concerns remain due to the expected slowdown in demand in FY08.

As Suratwala concludes, "Lack of presence in the light commercial vehicle segment and capacity constraints make us recommend an 'accumulate' on the stock."

For four-wheeler manufacturers, robust growth in volumes and increased demand remains only half the story. The other half with cost pressures, competitive pricing and prospects of more entrants could pinch margins significantly from FY08.